Académique Documents
Professionnel Documents
Culture Documents
by
Corry Silbernagel
Davis Vaitkunas
Bond Capital
With a supplement by Ian Giddy
MEZZANINE
MEZZANINE
EQUITY
Exhibit 1
Source: FitchRatings
Mezzanine capital is typically used to fund a growth opportunity, such as an acquisition, new product
line, new distribution channel or plant expansion, or in private business for the company owners to
take money out of the company for other uses or to enable management to buyout company owners for
Mezzanine Finance
succession purposes. Although it makes up a portion of a company's total available capital, mezzanine
financing is critical to growing companies and in succession planning in recent years.
The gap in funding between senior debt and equity is common for the following reasons:
1) accounts receivable, inventories and fixed assets are being discounted at greater rates than in
the past for fear that their values will not be realized in the future;
2) many balance sheets now contain significant intangible assets, and,
3) as a result of defaults and regulatory pressure, banks have placed ceilings on the amount of total
debt a company can obtain.
While additional liquidity can be obtained from equity investors, equity is the most expensive source of
capital. Further, equity capital, by its nature, dilutes existing shareholders. As a result, mezzanine debt
can be an attractive alternative way to obtain much needed capital.
Capital Structures
While there are no hard and fast rules for optimizing a companys capital structure, companies that are
ahead of the curve use an efficient combination of senior debt, mezzanine debt, and equity capital to
minimize their true cost of capital.
COMPANIES WITH EFFICIENT CAPITAL STRUCTURES EMPLOY
A NUMBER OF CAPITAL SOURCES
Expected
Returns
(%)
5% - 12%
Mezzanine
20% - 30%
13% - 25%
Equity
20% - 30%
25%+
Exhibit 2
In Exhibit 2, mezzanine debt is shown adding significant capital enabling a company to grow with no
dilution to Company owners. On the positive side: the owners face little dilution and maintain their
control of the business; the companies total cost of capital is reduced; and the mezzanine debt has a
flexible payment term that is structured as self liquidating and is paid off over time. On the negative
side this is a debt structure that requires interest payments over time.
Mezzanine Finance
Stretch
Mezzanine
Equity
Security
Secured
Partial
Subordinated
none
Ranking
Senior
First on Assets
Second
Third
Covenants
Tight
Tight
Flexible
none
Term
Demand
Term
Term / Patient
Patient
Coupon
Coupon - Fixed
Dividend
Rate
Prime
Prime Adjusted
Risk Adjusted
Market Adjusted
Equity Kicker
none
Success Fee
Warrants
Shares
Prepayment
Penalties
Yes
Yes
Fixed Period
No
Chartered Bank /
secondary lender
Private Capital
Private Capital
Recovery %
High
medium
Low
Low
Liquidity
High
medium
Low
Right of Sale /
Shotgun
Exhibit 3
Mezzanine Finance
now $15 million with the mezzanine layer compared with $7.5 million without. Ultimately this reduces
the equity requirement from $12.5 million to $5 million.
Banks often look more favorably on companies that are backed by institutional investors such as
mezzanine lenders and may extend more credit under more attractive terms. This is a result of the
mezzanine lenders' reputation, and the increased involvement of the mezzanine lender with the
company as compared with a bank alone. Simply put, the risk to the banks investment is reduced
because of their knowledge that the mezzanine lender through a more active role may enhance the
success of the business. Additionally, mezzanine lenders are a source of reserve capital for a business
owner helping to diversify a companys banking relationships thus reducing dependence on any one
lender.
Bank Debt
Mezzanine (non-bank Debt)
Equity
50%
60%
100%
50%
80% of company
value can be
released in Cash
20%
20%
Case 1:
Traditional
Case 2:
Typical Debt
Case 3:
High Leverage
Weighted Average
Cost of Capital
35%
19%
11%
Return on Equity
12%
21%
40%
Exhibit 4
The capital received by the companys owners can be used to diversify risk exposure to other
investments or retirement, to reinvest in the company, or to acquire other businesses.
Mezzanine Finance
Mezzanine History
Mezzanine lending has been around for more than two decades. In the 1980's, the business was
dominated by insurance companies and savings and loan associations. By the 1990's, limited
partnerships (LPs) had entered the arena. Today, investors include pension funds, hedge funds,
leveraged public funds, LPs and insurance companies, as well as banks that have established standalone mezzanine efforts.
Traditional mezzanine lenders are book-and-hold investors, generally focused on cash-flow lending,
looking for a minimum term (call protection) and equity participation to generate longer term results.
Unlike traded equity, high-yield debt, and interest rates which fluctuate with economic conditions,
traditional mezzanine finance is a consistent and stable market. The coupon rate on mezzanine notes
and targeted returns of mezzanine investments have remained relatively constant as shown in Exhibit 6.
30%
25%
20%
15%
Low
Median
High
10%
98
1)
99
00
01
This does reflect mezzanine returns which can vary based on company performance and loss ratio.
Exhibit 5
Mezzanine Finance
closer to four or five. Exhibit 7 depicts average debt multiples of leveraged companies and
differentiates between bank debt as a multiple of EBITDA, and non-bank debt (often mezzanine debt)
as a multiple of EBITDA. For example, an average US highly leveraged company with EBITDA of
$10 million per year in 2004 would have had 3.2 time EBITDA or $32 million in bank debt, with 1.0
times EBITDA or $10 million in non-bank debt. The ability of smaller companies (<$100 million in
revenue) in western Canada and the pacific northwest of the United States to attract senior debt levels at
this average is difficult, especially for non-traditional transactions and special situations. As a result of
reduced senior debt levels initially, the use of mezzanine capital is more relevant in this region.
MEZZANINE DEBT CAN PLAY AN INTEGRAL PART OF
A COMPANYS CAPITAL STRUCTURE
2.1
1.9
1.7
1.2
1.0
1.2
3.3
95
1)
3.5
96
3.6
97
3.5
98
3.3
99
1.5
1.4
1.7
2.2
2.4
2.3
01
02
03
3.2
2.9
00
04
0.7
3.6
05
Exhibit 6
Typically, mezzanine lending includes both subordinated debt and an equity component. The debt is
issued with a cash pay interest rate of 12 to 18 percent and a maturity ranging from five to seven years
with the ability of the borrower to buy out the debt earlier. The remainder of the required 15 to 25
percent all-in-return consists of warrants to buy common stock, which the investor values based on the
outlook of the company, or incremental interest paid on a "pay-in-kind" or PIK basis.
Mezzanine Exit
Most mezzanine investments are taken out either through a change-of-control sale or recapitalization of
the company. Many mezzanine capital providers believe the IPO "home run" is a rarity. While some
mezzanine providers may look to invest in companies that represent strong IPO candidates, more
frequently the mezzanine capital provider is bought out by the initial owner through a recapitalization
with inexpensive senior debt, through the accumulated profits generated by the business or through an
acquisition of the company by a competitor. The typical mezzanine transaction is for 5 to 8 years, with
the possibility of early exit.
Mezzanine Finance
Structure
Mezzanine financings can be completed through a variety of different structures based on
the specific objectives of the transaction and the existing capital structure in place at the
company. The basic forms used in most mezzanine financings are: subordinated notes
and preferred stock. Mezzanine lenders, typically specialist mezzanine investment
funds, look for a certain rate of return which can come from four sources: (each
individual security can be made up of any of the following or a combination thereof):
Mezzanine lenders will also often charge an arrangement fee, payable upfront at the
closing of the transaction. Arrangement fees contribute the least return and are aimed
primarily to cover administrative costs and as an incentive to complete the transaction.
Illustration. The following are illustrative examples of mezzanine financings:
In structuring a mezzanine security, the company and lender work together to avoid
burdening the borrower with the full interest cost of such a loan. Because mezzanine
lenders will seek a return of 14% to 20%, this return must be achieved through means
other than simply cash interest payments. As a result, by using equity ownership and PIK
interest, the mezzanine lender effectively defers its compensation until the due date of the
security or a change of control of the company.
Mezzanine financings can be made at either the operating company level or at the level of
a holding company (also known as structural subordination). In a holding company
structure, as there are no operations and hence no cash flows, the structural subordination
of the security and the reliance on cash dividends from the operating company introduces
additional risk and typically higher cost. The advantage to the company is that the debt at
the holding company level is not normally included in assessing the leverage or coverage
ratios that constrain how much a company can borrow.
- Ian Giddy